A quick look at the numbers for the first three quarters of 2011 suggests that there’s good news for the law firm industry—and some cause for concern. Collections were strong during the third quarter, but growth in demand slowed, leading to a notable reduction in the growth of inventory—work that has been performed but not yet collected on. So as firms headed toward the end of the year, they needed to consider carefully how hard to push for collections and how many expenses for 2012 to prepay in the fourth quarter of 2011.

For the first three quarters of 2011, revenue was up 5.2 percent across the industry, gaining momentum from the middle of the year. The increase was driven by strong inventory levels at the end of the first half of 2011, rate increases holding steady, and a likely continued improvement in realization—all of which offset the slowdown in demand growth.

Regarding demand, in our last article ["A Heavy Lift," November], we commented on market volatility caused by heightened concerns about the eurozone debt crisis and in the United States, the political stalemate, and stubbornly high unemployment. We also shared some anecdotal information suggesting that firms were concerned that demand for legal services, particularly transactional work, would be negatively affected.

Law firm leaders were right to be concerned. Cumulative growth in demand for the first nine months was 1.5 percent, down from 1.8 percent during the first six months. This indicates that growth in demand slowed to only 0.9 percent for the third quarter. This is likely a result of the slowdown in transactional work caused by the market shake-up. The slowdown has hit Am Law 50 firms (the 50 highest-grossing firms on The Am Law 100) particularly hard.

Our results are based on a sample of 183 firms: 44 Am Law 1–50 firms, 36 Am Law 51–100 firms, 49 Second Hundred firms, and 54 additional firms. Citi Private Bank provides financial services to more than 600 U.S. and U.K. law firms and more than 35,000 individual lawyers. Each quarter, the Law Firm Group confidentially surveys firms in The Am Law 100 and the Second Hundred, along with smaller firms. In addition, we conduct a more detailed annual survey. These reports, together with extensive discussions with law firm management conducted on an ongoing basis, provide a comprehensive overview of financial trends in the industry and insight into where it is headed.

Collections in the third quarter of 2011 were so strong that revenue growth outpaced expense growth. This was a reversal of the trend we had seen at the midyear point, when expenses were growing at a faster rate than revenue. The result was an easing of pressure on profit margin across the industry, and particularly for the Am Law 1–50 and Am Law 51–100 firms.

At 3.7 percent, rate increases held steady from the midyear point, continuing to slightly outpace the industry growth rates we saw in 2009 and 2010, though they are not back to the levels of 2001–08. Anecdotal evidence suggests that realization improved or at least stabilized for most firms. The rate increases and improved or stabilized realization may have contributed to an easing of pricing pressure throughout the first nine months of 2011.

Expenses, which had already risen by 4.7 percent during the first half of 2011, continued to gain momentum during the third quarter, as they have now increased 5 percent across the industry for the first nine months of this year. This was driven by a continued increase in operating expenses—and in compensation expenses, since we saw a slight uptick in head count during the third quarter, likely due to the entry of first-year associates.

This modest increase in associate head count, combined with the slowdown in demand in the third quarter, translated into a decline in productivity gains—from 1.6 percent growth for the first six months of 2011 to 0.9 percent growth for the first nine months.

The push for collections during the third quarter, along with the slowdown in demand, resulted in a significant slowing in inventory growth during the third quarter—3.6 percent for the first nine months (versus a cumulative growth rate of 6.3 percent for the first six months). The last time we saw the third-quarter inventory growth rate slowing from the first-half rate was in 2008.

There are some other trends we continue to track as well—equity partner growth rates, lateral partner movement, dispersion in performance among firms, the cost of the leverage model, and the increasing use of alternative fee arrangements.

We continue to see firms controlling equity partner head count, with either flat or negative equity partner growth rates for virtually all of the market segments we track. The flip side of this trend is the clear preference that firms in all segments are demonstrating for bringing in laterals over making promotions. Some firms are bringing in laterals to enhance their presence overseas and domestically, and it is difficult to do that with homegrown people. Some firms are focused on laterals to build up practice areas. And in a slow-growth environment generally, it is not surprising to see an uptick in lateral partner movement. So we think that will continue into 2012.

The widening dispersion in the performance of firms is another key trend we are watching carefully. The 2001–07 period was characterized by a relatively narrow dispersion in law firm performance, in contrast to the wide dispersion we saw in 2007–10. Our early analysis of 2011 firm profitability suggests that this will be another year of wide dispersion across the industry, comparable to the last couple of years. And that suggests further that we’ll continue to see a high degree of lateral movement.

We’ve recently begun highlighting in our roundtables the rising cost of leverage for law firms. Looking at the 100 most profitable firms from 2001 to 2010 in our database, we saw a discernible decline in the percentage of associates represented in the leverage composition and a significant growth in the income partner, counsel, and of counsel categories. The result is a much more expensive leverage model, which would be fine if these more expensive lawyers were as productive as equity partners and associates, but they are not. In looking at average annual lawyer productivity from 2001 to 2010, income partners and counsel worked about 150 hours less than equity partners and associates.

While we are not predicting the death of the billable hour, we are seeing an increasing proportion of alternative fee arrangements. This has many implications, including whether firms can generate the same levels of realization (and therefore, profitability) on these matters that they do on billable-hour matters. This is forcing firms to look carefully at the efficient delivery of legal services in ways they weren’t a few years ago.

As firms wrapped up 2011 and started 2012, we had two questions:

• Given the uncertainty regarding demand in 2012, will firms push hard to get every last dollar of revenue in the door by December 31, or will they push some revenue into 2012?

• Will firms aggressively prepay first-quarter 2012 expenses in 2011 as a hedge against this uncertainty?

The answers to these questions will both determine 2011 results and signal whether 2012 gets off to a slow or a flying start. Firms were painfully aware how important the fourth quarter was, particularly in the push for collections. The slowdown in growth of inventory—and the fact that the last time we saw this dynamic was in 2008—suggested that firms would have less room to navigate when making their year-end decisions about how hard to push for revenue versus waiting until 2012.

Two other wrinkles we’ve heard about anecdotally indicate that there could be further pressure on collection efforts. First, some transactional work was put on hold during the third quarter, and firms may not have been able to collect on unbilled time relating to that work in 2011. Second, firms were telling us that the soft demand environment continued into the fourth quarter. As of late November, our best guess was that firms would have to push hard to collect enough in 2011 to generate some growth in profits per equity partner (PPEP).

So we’re sticking to our forecast of low- to mid-single-digit growth in PPEP for the industry in 2011, which will fall a bit shy of 2010′s 7.5 percent increase. And if we’re right about the slowdown continuing into the fourth quarter of 2011, it will mean a rocky start to 2012.

Dan DiPietro and Gretta Rusanow are chairman and senior client adviser, respectively, at Citi Private Bank’s Law Firm Group. E-mail: dan.dipietro@citi.com; gretta.rusanow@citi.com.